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Thursday, May 19, 2011

Paul Krugman writes about a two-speed global economy where the emerging economies are experiencing rapid economic growth and rising inflation while the advanced economies remain in a slump. A key point he makes is that the countries still in a slump should focus on their own economic problems, not those of other countries. This especially applies to concerns about the Fed's monetary policy being exported across the globe:

What about complaints from other countries that they’re suffering inflation because we’re printing too much money? (Vladimir Putin has gone so far as to accuse America of “hooliganism.”) The flip answer is, Not our problem, fellas. The more serious answer is that Russia, Brazil and China don’t have to have inflation if they don’t want it, since they always have the option of letting their currencies rise against the dollar. True, that would hurt their export interests — but economics is about hard choices, and America is under no obligation to strangle its own fragile recovery to help other nations avoid making such choices.

He makes a fair point here in that the reason the Fed's policies are being felt overseas is because those affected countries have chosen to link their currency to the dollar. By linking to the dollar these emerging economies have made a decision to allow their monetary policy to be set in Washington, D.C. That is a choice outside the Fed's control.

Here is where I wish Krugman would go with his argument. Because these dollar block countries--all those emerging economies that either explicitly or implicitly peg to the dollar--are a significant share of the global economy, the BoJ and the ECB have to be mindful of what the Fed does too. If the BoJ and the ECB try to ignore the Fed's easing of monetary policy in the United States and in the dollar block countries, then they risk having their currency appreciate too much against a large portion of the global economy. That is why, as I noted earlier, the ECB could not possibly maintain its plans to steadily raise its targeted policy interest rate throughout the rest of the year. For better or for worse, then, the Fed is a monetary superpower.

Now if you buy this reasoning so far, think about this question: could the Fed's monetary superpower status have played a role in the global credit and housing boom in the early-to-mid 2000s? I say yes and explain why in this working paper.

Tuesday, May 17, 2011

In a recent speech you made the case for a more rules-based approach to monetary policy:

The Fed’s recent departures from rules-based monetary policy have increased economic uncertainty and endangered the central bank’s independence... Congress should end the Fed’s dual mandate and task the central bank instead with the single goal of long-run price stability. The Fed should also explicitly publish and follow a monetary rule as its means to achieve this goal.

I agree that we need a more systematic approach to monetary policy. The ad-hoc nature of the QEs adds uncertainty and makes the Fed a political lightning rod for criticism. Ultimately, this reduces the effectiveness of monetary policy. So, yes, we need a predictable, rules-based approach to monetary policy. We also need, however, an approach that responds appropriately to supply shocks. For example, we wouldn't want the Fed to follow a rule that would call for a tightening of monetary policy just because a major computer virus shut down most computer systems and, as a result, caused prices to go up. Instead, what we need is an approach to monetary policy that keeps the growth of total current dollar spending stable so that the booms and bust are minimized. The good news is there is a way for monetary policy to do this in a systematic manner. It is called nominal GDP level targeting. This approach would narrow the Fed's mandate to single measure and thus make it more accountable. I ask you to please consider this idea.

For further reading on nominal GDP level targeting I suggest you read this article, this article, and this article from the National Review.

Monday, May 16, 2011

I made the case in an exchange last year with Paul Krugman that QE2 was not the first time quantitative easing had been tried in the United States. Moreover, I noted that the original QE was a smashing success with nominal spending experiencing a robust recovery despite the zero bound problem. So when was this original QE program? The answer is from 1933-1936.

I bring this up now for two reasons. First, I just came across this short essay by Richard G. Anderson of the St. Louis Fed that confirms my view that the monetary stimulus program during this time was effectively a QE program (though he says it started in 1932). Second, the original QE program provides a nice counterexample to the more modest accomplishments of QE2. This QE program was put in motion by FDR telling the public he wanted to return the price level to its pre-crisis level. In other words, FDR was signalling a price level target. Gautti Eggerton shows it was well understood by the public. FDR backed up his price level target by getting the Fed to buy more securities, by getting approval (via Congressional pressure) for the U.S. Treasury to issue currency, and by devaluing the gold content of the dollar from $20.67 to $35 a ounce. These actions sent an unmistakable signal to the public that they should take the price level target seriously.

Now the price level did not fully return to its pre-crisis level until the early 1940s, but the expectation that it would spurred a robust recovery through 1936. (It probably would have lasted longer had the Fed not snuffed it out.) The original QE success, therefore, occurred because there was a price level target that properly shaped expectations. QE2, on the other hand, was not implemented with a price level target and even the Fed's implicit inflation target was and is not clearly defined.* Thus, its results have been more modest.** Ryan Avent recently summed up QE2 very nicely. He said QE2 changed the direction of monetary policy, but it didn't set the destination. That is the problem.

*Though a price level target would have been a vast improvement, it is not always ideal because it handles supply shocks poorly. Thus, a better choice is a nominal GDP level target.

**It also did not help that the U.S. Treasury was increasing the average duration of public debt during QE2.

Sunday, May 15, 2011

Paul Krugman appreciates my efforts against the hard money advocates. He questions, however, my and other quasi-monetarists' belief that monetary policy can still pack a punch when short-term interest rates hit the zero bound:

[T[hey want to keep that policy action narrowly technocratic, limited to open-market operations by the central bank. As I’ve argued before, this doctrine has failed the reality test: liquidity traps are real, and blithe assertions that central banks can easily pump up demand even in the face of zero short-term rates have not proved correct.

It is true that us quasi-monetarists believe that the efficacy of monetary policy is not limited by the zero bound, but we have never said the that all it takes is further open-market operations. Rather, we have said that monetary policy can be highly effective regardless of circumstance if the following steps were taken by the Fed:

(1) Set an explicit nominal GDP level target so that expectations are appropriately shaped. If such a rule were adopted expectations of current and future nominal spending would be anchored around the level target and make it less likely there would be aggregate demand crashes like the one in late 2008, early 2009. Even if a spending crash did occur the catch-up growth needed to return nominal spending to its level target would most likely imply an expected path of short-term real interest rates consistent with restoring full employment. (See here, here, and here for more on a nominal GDP rule.)

(2) Purchase assets other than t-bills as needed to make sure the nominal GDP level target is maintained. Thus, if the monetary base and t-bills became perfect substitutes because the 0% bound is reached the Fed should buy longer-term treasuries or foreign exchange. Nowhere have we said simple open market operations in t-bills would always suffice. A big difference, though, is that where Krugman and others see the move from t-bills to other assets as a discrete jump from conventional to unconventional monetary policy, quasi-monetarists see it as simply moving down the list of assets that can affect money demand. The 0% bond for us really is not a big deal, but simply an artifact of monetary policy using a short-term interest rate as the targeted instrument.

In practice, this understanding is not that different operationally than a New Keynesian invoking a higher inflation target to lower the expected path of real interest rates or the portfolio channel to drive down the term premium on long-term bonds. We just do it with a lot less angst. Maybe Andy Harless with his modified Taylor Rule can bridge the gap between us.

Finally, because of these views we believe the Fed could have done much more in late 2008, early 2009. Its failure to do so amounted to a passivetightening of monetary policy then. Even now monetary policy is not all that loose given that money demand continues to be elevated. Don't believe me? Then just look at domestic spending per capita, it is still below its pre-crisis peak.

Friday, May 13, 2011

There is an interesting article on Bill Gross and PIMCO in The Atlantic. It highlights PIMCO's decision to dump and then bet against U.S. treasury bonds. According to Tyler Durden, the amounts involved are significant. Bill Gross' explanation for these decisions is that the bond market is being artificially propped up by QE2 and once it ends so will bond prices.

These decisions have me stumped. First, Gross' view assumes that the flow of QE2 purchases is what matters to bond prices. There are good reasons to think, however, that it is the stock of QE2 purchases that matter. If so, there should be no bond market correction since the Fed is not planning to sell its newly-acquired assets anytime soon. Second, given the weak economic outlook the expected short-term interest rates going forward should remain low. That in turn should translate into low long-term bond yields. Finally, if PIMCO's view were correct would not the bond market be pricing it in already? The figure below gives no indication of the U.S. bond market bottoming out. If anything, there is a downward trend in the long-term treasury yield since the start of the year.

Now Bill Gross and the folks at PIMCO are smart. They saw the housing bust well in advance and have made lots of money over the past few decades. So when they place so big a bet against U.S. bonds it should give us pause. Maybe they are bond vigilante harbingers. Or maybe they are wrong. For now the bond market seems to be supporting the latter view.

Hard money advocates have been taking a beating in the blogosphere over the past few days, complements of Matthew Yglesisas, Paul Krugman, Mike Konczal, and Ryan Avent. These critics make some good points about the hard money view. Here is Avent's critique:

The hard money approach is atrocious economics. I don't think it's outlandish (or even particularly controversial) to say that the biggest difference in the outcome of the Great Recession and the Great Depression was the change in central bank approach to policy. An economic catastrophe was averted. What's more, hard money is a great force for illiberalism. Sour labour market conditions fuel anger at the institutions of capitalism and free markets. And when countries are denied the use of normal countercyclical policies, they quickly reach for illiberal alternatives like tariff barriers.

These points are often overlooked by hard money supporters. There is, however, an even bigger problem for them. Most hard money advocates are in the GOP which also happens to be calling for fiscal policy restraint. The belief is that hard money and sound government finances are necessary for a robust recovery to take hold. The problem is that the hard money approach--which means tightening monetary policy--makes it next to impossible to stabilize government spending. It also makes it likely the economy will further weaken.

How do we know this? First, in almost all cases where fiscal tightening was associated with a solid recovery monetary policy was offsetting fiscal policy. Last year there was a lot of attention given to a study by Alberto F. Alesina and Silvia Ardagna that showed large deficit reductions were often followed by rapid economic expansion. Further digging by the IMF and by Mike Konczal and Arjun Jayadev found, however, that this was only true when monetary policy was lowering interest rates. Fiscal tightening coincided with a recovery only because monetary policy was easing.

Second, a key lesson of recent years is that monetary policy overwhelms fiscal policy. Thus, from 2008-2009 when monetary policy was effectivelytight the easing of fiscal policy didn't quite pack much of a punch. Similarly, in late 2010, early 2011 when there was not much fiscal stimulus, but some monetary policy easing under QE2 there was some improvement in the pace of recovery.

Third, another lesson from the recent crisis and the Great Depression is that if tight monetary policy is dragging down the economy it opens the door for more active fiscal policy. Imagine if the Fed had been able to stabilize nominal spending more effectively and thus prevented the economic collapse in late 2008, early 2009. It would have been a lot harder to justify the large fiscal stimulus package. The same is true for 1929-1933. Had the Fed not been passively tightening monetary policy at that time there would have been far less political support for fiscal policy and government intervention in the economy.

All of this indicates that calls for tight monetary and tight fiscal policy simply don't make sense for the GOP. Such an approach would most likely cause the cyclical budget deficit to increase even if the GOP successfully lowered the structural budget deficit. More importantly, with tight monetary policy there would probably be no recovery to show for the budget deficit cutting. This would make it politically tough to do further fiscal reforms. If the GOP wants to meaningfully address budget problems it needs to soften its stance on monetary policy. Otherwise, it risks becoming its own worst enemy.

Tuesday, May 10, 2011

One of the arguments I have made over the years on this blog is that the Fed is a monetary superpower. It manages the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy gets exported to much of the emerging world. This means that the other two monetary powers, the ECB and Japan, have to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. Thus, we have seen these two countries move their policy rates in line with what the Fed does usually with a lag.

The recent interest rate hike by the ECB in the absence of a similar move by the Fed goes against this pattern. Does it mean the ECB is finally breaking free of the Fed's orbit of influence? It could be, but I doubt it. The ECB raised its policy rate in April and was talking up further rate hikes throughout the year. Last week, however, the ECB backtracked to some degree by avoiding a further rate hike. It also has toned down its rate-hiking rhetoric. Some of this is directly due to the problems in the Eurozone. Just as important, though, is the concern that if the ECB were to follow through on all of it rate hikes the Euro would get intolerably expensive against the dollar and the dollar-pegging countries. I interpret these developments as the ECB facing up to reality of their proposed tightening cycle. It is not the first time they tried to tighten while the Fed was easing. In mid-2008 the ECB tried increasing interest rates while the Fed was lowering its target rate. This didn't last long as seen in the figure below:

I suspect that as long as the Fed keeps the expected path of the federal funds rate at low levels, the ECB will not be able to raise its interest rates. For the time being, the Fed remains a monetary superpower.

P.S. I have a working paper with Chris Crowe where we more fully develop the view that the Fed is a monetary superpower. You can find it here. Comments are welcomed.

Monday, May 9, 2011

[E]ven if the press conferences do improve how the Fed communicates, and dampen the volatility of market responses, the real problem is what the Fed communicates. The Fed still does not communicate two things: (1) a clear numerical objective for policy; and (2) any idea of the monetary policy path it expects to use to get to its objective.

Hanson notes that the reason for this lack of clarity is the Fed's dual mandate. He cites research by Nicholas Herro and James Murray that shows the uncertainty created by this lack of clarity is costly to the economy. If only there were a way to narrow the Fed's mandate that so that there would be increased clarity and improved macroeconomic stability. Oh wait, there is a way.

The Kauffman Economic Outlook, a survey of economics bloggers, is out for Q2. The survey had two interesting questions on the Fed, one of which I submitted. Thanks to Tim Kane for including it in the survey. Here is the question and the results:

I am not entirely surprised by these results. Most popular accounts and thus the emerging narrative about this experience either downplay or ignore the studies that have shown the monetary policy was a major contributor. I won't rehash them here, but will note that I am editing a book that does shift the focus back to the role the Fed played in the boom and the bust. Stay tuned for more news on the book.

I was very surprised to see the responses to the second Fed question. It was submitted by Bryan Caplan and Steve Miller:

Wow. Only 16% of the economic bloggers believe the Fed has had a net negative effect while 40% think the Fed has been good on balance. This is surprising. These folks need to read the assessment of the Fed by George Selgin, William D. Lastrapes, and Larry H. White.

Over at The Economist there is an interesting debate taking place between Brad DeLong and Bennet McCallum. They are responding to the following statement: this house believes that a 2% inflation target is too low. The idea behind this statement is that with a higher inflation rate the targeted short-term nominal interest rate would be higher and thus less likely to hit the 0% bound. Brad DeLong endorses this view. He sees the 0% bound as a real constraint on monetary policy and wants to avoid it. Bennet McCallum challenges it. He argues that monetary policy is not powerless at the 0% bound and there are real costs with going to a higher inflation target.

A key issue to resolving this debate is how binding the 0% bound is for monetary policy. My own view is that it is not truly a binding constraint, but only a self-imposed one because of the way monetary policy is normally conducted. Conventional monetary policy targets a short-term nominal interest rate. So when the 0% bound is reached monetary authorities have to switch over to their "unconventional" monetary policy bag of tricks. But it doesn't have to be this way. Imagine if the Fed targeted the price level at a 2% growth rate and didn't use the federal funds rate as its instrument. It simply adjusted the monetary base to hit the price level target and communicated very clearly its goals to the public. Assume that as part of this communication the Fed said it would do whatever is necessary to hit its target, including buying other assets than just t-bills if the need arose.

In that setting it is hard to imagine why the 0% bound on the short-term interest rate would ever matter. First, the 0% bond would rarely be reached because nominal expectations would be well anchored. Second, even if it did, say because of a major aggregate demand shock that caused deflation, the price level target would require significant catch-up inflation that would lower the expected path of real interest rates presumably enough to restore full employment. Over the long-run there would be price level stability as the price level returned to trend and 2% growth. Thus, the 0% bound would not matter and there would be no need for permanently higher inflation.

On the catch-up inflation scenario above, something similar happened during the 1933-1936 period. FDR communicated clearly that he wanted the price level to return to its pre-crisis level and backed up his talk with the devaluation of the gold-content of the dollar and deciding not to sterilize gold inflows. (See Gautti Eggertson and this for more.) Short-term rates were at the 0% bound at this time too. Nonetheless, this monetary easing sparked a remarkably robust recovery that was unfortunately cut short.

What all this means is that we can have our cake and eat it too. If the Fed were too adopt an explicit price level target and vow to hit it no matter what (i.e. engage in other asset purchases if necessary), then Brad DeLong would get some higher-than-normal catch-up inflation and Bennet McCallum would not have to worry about a permanently higher inflation rate. Better yet, if the Fed were to adopt a nominal GDP level, then DeLong and McCallum wold get all the above benefits plus the fact that the Fed would not be responding inappropriately to aggregate supply shocks.

P.S. See the recent posts by Josh Hendrickson and myself on why the 0% bound typically is not enough to create a liquidity trap.

Sunday, May 8, 2011

Greg Mankiw recently referred to a paper where he assess which inflation rate should be targeted by the central bank. Here is his conclusion:

[A]central bank that wants to achieve maximum stability of economic activity should use a price index that gives substantial weight to the level of nominal wages.

There are several good reasons laid out in the paper for targeting nominal wages. Here I like to point out that stabilizing nominal wages is similar to stabilizing nominal income per capita. It is not too much of a stretch to go from this to a nominal income or nominal GDP target. In fact, Greg Mankiw and Robert Hall have a 1994 paper that sings the praises of a nominal GDP target, especially one that that targets the the consensus forecast of the nominal GDP level.

So where does Greg Mankiw stand today on nominal GDP level targeting? If he still supports it, does he see the need to return nominal GDP back to its pre-crisis trend or at least higher than its current level? These are not just academic questions. First, money demand in the United States remains elevated and, as a result, nominal spending is anemic and below any reasonable trend. A nominal GDP level target would empower the Fed to meaningfully address this problem while still keeping long-term nominal spending expectations stable. Second, some in the U.S. Congress want to narrow the Fed's mandate. Adopting a nominal GDP level target is a great way to do that, as I argue here. It would be nice to hear Greg Mankiw's answers to these questions.

Friday, May 6, 2011

In Newsweek the pundit claims that “double-digit inflation is back”: “The way inflation is calculated by the Bureau of Labor Statistics has been ‘improved’ 24 times since 1978. If the old methods were still used, the CPI would actually be 10 percent.” If Ferguson is right about inflation, it leaves two possibilities. Either our statistics on the size of the economy in current-dollar terms–which ought to be easier to compile than any numbers on inflation–are hopelessly flawed. Or the real (that is, inflation-adjusted) size of the economy is shrinking rapidly. Instead of 1.8 percent real growth, in the last few months we’ve been going through something more like 7 percent real shrinkage. (Nominal growth, remember, has to equal inflation plus real growth.) Is that even remotely plausible? Does Ferguson believe this rate of shrinkage is compatible with even the modest job increases we’ve seen? Or does he doubt the unemployment stats too?

With that lesson out of the way, Ferguson's assignment is to now read Ponnuru's latest piece on monetary policy in the National Review. Class dismissed.

Matt Rognlie takes to task Tyler Cowen for claiming there is no liquidity trap. He makes his case for the liquidity trap and then closes with this statement:

This doesn’t mean that all hope is lost: the Fed can still make a difference by shaping expectations of the future trajectory of nominal interest rates, or by making unconventional bond purchases so large that they trigger portfolio balance effects and drive down interest rates on longer-maturity assets...Just don’t go around claiming that 0% isn’t a barrier—because sadly, it is.

Ironically, the above bold phrase is exactly why in most circumstances there is no liquidity trap at the 0% barrier. To see this, first recall that a liquidity trap is a situation in which the demand for money is perfectly elastic. That is, no matter what the central bank does it cannot cause money demand to budge. Monetary policy, therefore, is unable to address the problems created from excess money demand in a liquidity trap.

Now Rognlie claims this happens once the central bank's targeted short-term interest rate hits the 0% barrier. This assumes that money demand is only affected by the targeted short-term interest rate. Milton Friedman argued, however, that money demand is affected by a spectrum of interest rates and that there is still much the Fed can do when the short term interest rate hits 0%. The Fed can still go after long-term treasury yields and corporate bond yields which Friedman believed were also important determinants of money demand. If so, money demand can still be influenced by the Fed and thus there is no liquidity trap.

The portfolio balance channel mentioned by Rognlie above is implicitly making this very point. In that channel, the Fed through its purchases of longer-term securities can drive down longer-term yields. This causes a rebalancing of portfolios that will lead to purchases of normally riskier assets like stocks and capital. These developments imply a decline in money demand. Thus, to claim there is a portfolio balance channel is to claim that there is no liquidity trap at the 0% bound of the short-term interest rate. Rognlie's endorsement of the portfolio balance channel, then, implies Tyler Cowen's skepticism of the liquidity trap is well founded.

So is there any evidence that money demand can be influenced by a spectrum of interest rates? Some older studies do show this, but for now here are three figures that suggest that answer is yes. They all show MZM velocity (i.e. GDP/MZM) to be systematically related to various interest rates. (The R2 for these relationships is always above 70%.)

In general, the 0% bound on short-term interest rates is not a sufficient condition for a liquidity trap. It requires individuals to become satiated with money balances which implies there must be deflation. Even then, Peter Ireland has shown using the Krugman liquidity trap model that if there is population growth then there will be distributional effects of money growth that will eliminate the liquidity trap.

Currently, we are far from a liquidity trap though money demand remains elevated and a drag on the economy. That being the case, there is much that monetary policy could do to address the excess money demand problem and get nominal spending going again. Here is one suggestion.

Maybe this is why the ECB decided to hold off on the interest rate hike:

The debt crisis in Greece has taken on a dramatic new twist. Sources with information about the government's actions have informed SPIEGEL ONLINE that Athens is considering withdrawing from the euro zone. The common currency area's finance ministers and representatives of the European Commission are holding a secret crisis meeting in Luxembourg on Friday night.

Thursday, May 5, 2011

Commodity prices took a beating today. This Bloomberg headline sums it up well: Commodities Sink Most Since 2008 as Stocks Fall. But how can this be? We have been told repeatedly that the surging commodity prices are because of the Fed's loose monetary policy. But U.S. monetary policy did not suddenly tighten. So what caused the drop in commodity prices? For those of us who have been arguing U.S. monetary policy has not been driving commodity prices, the answer is implied by this figure:

This figure indicates that the rapid growth of emerging economies is probably the real reason for the rapid changes in commodity prices over the past few years. This view is further borne out by evidence from the San Francisco Fed, Chicago Fed, and Marcus Nunes. The reason, then, for today's fall in commodity prices appears to be the buildup of bad economic news that suggests the world economy and in turn the emerging economies may be slowing down. Now this is only a one-day move, but according to Felix Salmon it is a 5.4 standard deviation move that lines up nicely with the weakening global economic outlook. I just hope all the inflation hawks and hard-money types will use this experience as a "teachable moment."

The ECB decided today to hold back from another interest rate hike. It seems the ECB has finally figured out that the series of interest rate hikes it intended to do this year probably would have caused the Eurozone some harm. Specifically, the ECB's proposed tightening would have required more painful deflation in the Eurozone periphery to bring about the real depreciation that part of the currency union sorely needs. That much the ECB seems to understand. What they don't seem to understand or don't want to understand is that the periphery's real depreciation could also occur through higher inflation in the core. That, however, would require the ECB to ease and allow more inflation in Germany, an unlikely event.

The ECB also hasn't seemed to figure out that being passive is effectively keeping monetary policy tight. Nominal GDP remains well below trend, the Euro is surging, and the ECB balance sheet is slowing shrinking. Michael T. Darda appropriately calls these developments the caustic concoction brewing in the Eurozone. How much longer can this go on? If only the ECB would learn the lessons of the Fed's passive tightening in 2008.

Current dollar spending per person in the United States is still below its pre-crisis peak. In 2008:Q2 domestic spending per capita was $50,081. In 2011:Q1 it reached 49,808. So 11 quarters later, the U.S. economy has yet to even return to its pre-crisis peak, let alone get anywhere near a reasonable pre-crisis trend. Time to adopt a nominal GDP level target.

Matt Rognlie says no. Nick Rowe says yes and I agree. Nick Rowe argues MV=PY (where (M = money supply, V = velocity, PY = nominal GDP) is useful because it highlights the fact that money is special: it is the only asset on every other market (i.e. it is the medium of exchange) and thus is the only one that can affect every other market. Money, therefore, is what makes it possible to have economy-wide recessions. Even in the recent recession where the financial crisis increased the demand for safe assets, it was not the elevated demand for safe assets itself that caused the recession but the fact that this demand for safe assets was met, in part, by going after the safe asset money.

I view the equation of exchange as useful because it provides a summary measure of what is causing swings in nominal spending and the role, if any, monetary policy is playing in those swings. For example, the equation of exchange in its expanded form sheds a lot of light on what caused the crash in nominal spending during late 2008, early 2009. It also explains why the subsequent recovery in nominal spending has been sluggish.